Very little typically happens in Europe during the summer holidays, when policymakers and everyone else go on vacation. The summer of 2012 was an anomaly with the famous promise to do “whatever it takes” comment by Mario Draghi, president of the European Central Bank, in late July. Draghi’s remarks ushered in a period of relative calm in peripheral bond markets. What is in prospect a year later?

Politically, Europe faces some volatility in several euro area member countries. Ironically, the campaigns in Germany and Austria will deliver calm and continuity. Chancellor Angela Merkel looks increasingly secure in her reelection bid, and may even get to keep her current Christian Democratic Union-led coalition. There may be enough CDU voters shifting to the coalition junior partner, the Free Democratic Party, to push it above the 5 percent voting threshold needed to get into Parliament. Until recently, that achievement has been in doubt.

Merkel is also more popular than her Social Democratic Party (SPD) challenger, Peer Steinbrück, who lacks a major mobilizing political issue, and is buoyed by a domestic German economy close to full employment. Few controversial issues are likely to block her path to reelection. More financial aid to Greece, a subject that infuriates parts of the CDU, is not in the offing in the short-run. The complex issues surrounding the European banking union arouse limited voter interest and have seen substantial progress in recent months.

And even if a YouTube video of Merkel listening to PRISM recordings were to surface, and Steinbrück were to pull off an upset, German policy would not change much. SPD policies would be different from what have been espoused in opposition. They would resemble the policies that have made Merkel popular. In Germany, anyway, everything important is decided by a grand coalition majority.

The political situation in “peripheral” southern Europe is far more unsettled, but Greece, Spain, and Portugal share the goal of avoiding early elections that could introduce instability. The situation in Greece and Portugal, as discussed earlier on RealTime, is similar. Their economic policy is essentially dictated by the Troika consisting of the European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF). Their political strategy is to swallow hard and hope for a turnaround before the next scheduled elections in 2015/16, but this approach is fracturing their governing coalitions. The junior coalition partners in both countries are restless and eager to position themselves against the Troika policies. Yet, because these smaller parties remain tainted by their responsibility for these policies until now, they are unlikely to bolt and force new elections with their countries still in recession. Delay also means their euro partners will not blame them for the market instability new elections would cause. The economic policies in Greece and Portugal are not likely to change much.

Ruling Coalitions Have an Incentive to Hang On

President Aníbal António Cavaco Silva’s recent call for a new national unity government until elections in early 2014 has predictably failed. The opposition Socialist Party in Portugal, which is far from radical, would only join if it could get concessions from the Troika, whereas the ruling party would seek such concessions for itself. Prime Minister Pedro Passos Coelho will thus stay and enter into increasingly likely negotiations with the Troika about a program and loan extension well before the next scheduled elections in 2015. President Silva, in calling for a national unity coalition, seemed to be trying to grant the Socialists a veto over the new program. He was trying to increase Portugal’s bargaining power with the Troika, though the Troika is unlikely to give much ground. The fact is, neither country has a credible strategy of threatening to withhold cooperation with the Troika. Were they to stop implementing reforms, and invite a funding cutoff, they would suffer more than the rest of the euro area. Contagion risk from non-compliance in these smaller economies to the systemic-level euro area countries (e.g., Spain and Italy) is limited with the Outright Monetary Transactions (OMT) in place. One of the many benefits of Mario Draghi’s initiative last year has hence been to dramatically limit the political bargaining power of small peripheral countries in the euro area.

For Greece and Portugal, No Choice but to Carry On

On the surface of it, the Troika’s ability to dictate economic policies to countries it is helping is undemocratic. Those policies, moreover, are causing enormous economic stress. Many agree that Greece and Portugal need more time to undertake reforms. But unfortunately, Greece and Portugal need the money. Without further debt relief from the euro area, Greece will be unable to return to full market access for its debts. Portugal’s return in early 2014 also looks doubtful. Like it or not, they are captive to the political necessities in other euro area countries, which cannot acknowledge publicly that more debt relief is possible. But as discussed on RealTime, the reality is different. More money for Portugal and Greece is politically possible, provided that two basic conditions are met:

The alternative has to be worse: Throughout the euro area crisis, the previously politically impossible suddenly became possible when the euro itself was at risk. So to now in the case of Greece, where the alternative to some form of debt relief for Athens is that the euro area has to keep funding the government in the absence of future market access. Similarly in Portugal, where the euro area would be reneging on earlier explicit promises to continue to support countries in compliance with their Troika programs, were they to suddenly cut of financing. This would leave Portugal with no other option that to default, undermining the euro area often repeated mantra that “Greece is a unique case.”

Structural reform homework comes first: Lots of commentary and analysis indicate that there is an “optimal reform sequencing” for peripheral euro area countries, where fiscal loosening provides immediate economic breathing space and enables structural reforms to function better. This is unsurprisingly the preferred policy option of the domestic government in any crisis country, as well as analysis driven by short-run macro-economic model forecasts. However, it ignores the crucial political economy of the other euro area countries, which dictates that these types of im/explicit fiscal transfers are only politically possible, as “ex post solidarity” with a country that has been implementing its Troika programs.

Greece and Portugal thus have no choice but to push through the Troika policies, take credit for any fiscal easing they are granted if their economies lag, and obtain the euro area seal of approval for additional financing.

What Happens after the German Elections?

Will Greece seek debt relief after the German elections, hoping that Berlin will then be more accommodating? If so, they are going to be disappointed. Greek debt relief has not been an election issue in Germany. None of the big German parties are likely to give Athens relief without more progress on structural reform. The German finance minister, Wolfgang Schaüble, was very clear on this issue on his recent visit to Athens. He said it would “not be in the interest of Greece to continue this discussion [about early debt relief].” Schaüble also told a German radio interviewer that it was “possible” Greece would need a program, but that “if then Greece still needs help, we will be prepared to speak constructively with each other—now Greece needs to fulfill what it must do for 2013, which is difficult enough, but they’re doing it.”

The same sentiment was expressed recently by Michael Fuchs, the CDU deputy leader in the Bundestag, who told a Bloomberg interviewer on July 10 that Greece might envision a restructuring of its publicly held euro area debt “in 2014 at the earliest, or 2015, on condition reforms take effect.”

While Greece waits for its ultimately necessary debt relief, some euro area flexibility towards both Portugal and Greece on the shorter-term financing targets seems likely. Portuguese president Silva’s latest gambit certainly suggests he has taken these lessons onboard, and the short-term implementation of Portugal’s commitments by the current government hence looks relatively unproblematic. Lisbon knows that the best chance of getting “fiscal goodies from the euro area” lies in doing—or at least trying hard to—its homework first.